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STUDY: High Frequency Trading Makes Markets More Fair

Photo: Getty / Chris Hondros

High-frequency traders have a pretty bad reputation in the Australian media thanks to vocal opponents that are unhappy about losing out to faster, more expensive technology.

But a new research paper from the Capital Markets Cooperative Research Centre (CMCRC) and its research partners argues that HFT actually makes markets more fair by mitigating the effects of market manipulation.

The study involved 22 exchanges in Australia, Canada, China, Germany, Hong Kong, India, Japan, Malaysia, New Zealand, Norway, Singapore, South Korea, Sweden, Switzerland, Taiwan, the UK and US.

HFT accounts for about 50-70% of US trades, 40% in Canada, 35% in London and about 15%-20% of ASX equities trading.

Researchers looked at data from 2003-2011 to determine the effect of HFT activity on closing prices. They found that markets with “a significant presence of HFT” experienced almost 21% fewer cases of suspected manipulation of closing prices.

From the report:

‘Closing’ or ‘end-of-day’ (EOD) prices are extremely important for a number of reasons, including the fact that they are often used to determine the expiration value of derivative instruments and directors’ options, price of seasoned equity issues, evaluate broker performance, compute net asset values of mutual funds, and compute stock indices (Comerton-Forde and Putnins, 2011).

As such, there is massive incentive to manipulate closing price by ramping up end of day trading to push the closing price to an artificial level.

[...]

Suspected cases on EOD price dislocation are based on consideration of a significant increase in the EOD returns, trading activity in the last part of the day, and bid-ask spreads, as well as a reversion to natural price level the following morning.

CMCRC CEO Professor Michael Aitken said policy mechanisms, including trading rules, surveillance and enforcement, appeared to have had less of an effect in mitigating EOD price dislocation than HFT, suggesting that the market may indeed be capable of disciplining itself.

“There is an established negative relationship between liquidity and EOD prices – the higher the liquidity the harder it is to manipulate or the less prices will move,” he explained.

“HFT, by either providing additional liquidity at these points or because market participants know that HFT are present in a marketplace, appears to reduce EOD dislocation, whether it is caused by fair means or foul.”

The full research paper is here.

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